Financial Stability 2 07
D e c e m b e r
Reports from the Central Bank of Norway
No. 5/2007
Norges Bank’s reports on financial stability
Financial stability implies that the financial system is robust to disturbances in the economy and can channel capital, execute payments and redistribute risk in a satisfactory manner.
Pursuant to the Norges Bank Act and the Payment Systems Act, Norges Bank shall contribute to a robust and efficient financial system. Norges Bank therefore monitors financial institutions, securities markets and payment systems in order to detect any trends that may weaken the stability of the finan�
cial system. Should a situation arise in which financial stability is threatened, Norges Bank and other authorities will, if necessary, implement measures to strengthen the financial system.
Experience shows that the foundation for financial instability is laid during periods of strong debt growth and asset price inflation. Banks play a key role in credit provision and payment services – and they differ from other financial institutions in that they rely on customer deposits for funding. Banks are thus important to financial stability. The Financial Stability report therefore focuses on the prospects for banks’ earnings and financial strength and the risk factors to which banks are exposed. Developments in credit, liquidity and market risk are assessed.
The report is published twice a year. The main conclusions of the report are summarised in a submis�
sion to the Ministry of Finance. The submission is discussed at a meeting of Norges Bank’s Executive Board. Norges Bank’s annual Report on Payment Systems provides a broader overview of developments in the Norwegian payment system.
Financial Stability and the Monetary Policy Report together comprise Norges Bank’s report series. The report is also avail� The report is also avail�The report is also avail�
able on Norges Bank’s website:
http://www.norges�bank.no.
The series of reports is included in the subscription for Economic Bulletin. To subscribe please write to:
Norges Bank, Subscription Service P.O. Box 1179 Sentrum
N�0107 OSLO NORWAY
Telephone: +47 22 31 63 83 Telefax: +47 22 31 64 16
E�mail: central.bank@norges�bank.no Editor: Svein Gjedrem
Design: Grid Stategisk Design AS
Setting and printing: Tellus Works Reclamo AS The text is set in 11½ point Times
ISSN 1502�2749 (printed), 1503�8858 (online)
Financial Stability 2/2007
Editorial 5
Summary 6
1. Financial institutions 8
2. The macro-financial environment 15
3. Outlook and challenges 31
Boxes
Problems in the US residential mortgage market 42 Problems in interbank markets - central bank liquidity
measures 44
Covered bonds 47
Stress testing of banks’ losses and results 48
Annex 1 Boxes 2003 – 2007 51
Annex 2 Other published material on financial stability
at Norges Bank 52
Annex 3 Statistics 53
This report is based on information in the period to 30 November 2007
Editorial
Important to be prepared for crises
There is still considerable turbulence in money and credit markets. The problems started in the US sub�prime mort�
gage market. The turbulence spread to the money and credit markets when it became clear that many banks in the US and Europe would have to carry doubtful loans on their own bal�
ance sheets. There is now considerable uncertainty as to the effects of the financial turmoil on international banks’ results, capital adequacy and willingness to extend loans. Norwegian banks are feeling the impact of the turbulence through higher funding costs and losses on securities holdings.
Even though banks and authorities were aware of the prob�
lems in the US mortgage market, many were surprised by the way in which and how rapidly the problems spread. This is a reminder that both banks and authorities must be well pre�
pared for financial crises.
The most important measure to prevent financial crises is a set of rules that do not provide the wrong incentives. The new capital adequacy rules (Basel II) redress many of the shortcomings in Basel I and are therefore a step in the right direction.
An important element in Basel II is that banks are required to conduct stress testing in order to assess total capital needs.
This autumn’s turbulence shows that it is important to test the vulnerability of banks’ funding. Experience shows that banks must not restrict themselves to previous events when preparing stress alternatives. It is also important that banks conduct crisis simulation exercises and draw up contingency plans that can be rapidly implemented and that address dif�
ferent types of events.
The authorities must also work on stress testing and crisis simulation. Norges Bank is currently developing a new stress testing tool that can better analyse the impact on banks of dif�
ferent shocks to the Norwegian economy. The results of these tests will be regularly presented in the Financial Stability reports. A large�scale crisis simulation exercise for the authorities in the Nordic and Baltic countries has also been conducted this autumn. The exercise provided useful insight into how the authorities can manage a crisis in a cross�border bank. It also showed that the coordination of measures to address a crisis is demanding and that many issues remain unresolved.
Svein Gjedrem
Summary
0 0.3 0.6 0.9 1.2 1.5
1998 1999 2000 2001 2002 2003 2004 2005 2006 20070 2 4 6 8 10 12 14 Chart 1 Banks’ capital ratio and pre-tax profit as a percentage of average total assets.1)
Annual figures. 1998 – 2006 and at 2007 Q3
1)Excluding branches of foreign banks in Norway Source: Norges Bank
Profit before loan losses and write-downs (left-hand scale)
Profit after loan losses and write-downs (left-hand scale) Capital ratio (right-hand scale)
Chart 2 Banks’1)gross stock of non-performing loans. Percentage of gross lending to sector.
Quarterly figures. 97 Q1 – 07 Q3
1)All banks in Norway Source: Norges Bank 0
1 2 3 4 5
1997 1999 2001 2003 2005 2007
0 1 2 3 4 5
Households All sectors
Enterprises
0 1 2 3 4 5 6
1987 1990 1993 1996 1999 2002 2005 0 1 2 3 4 5 6
Source: Norges Bank
Chart 3Banks’ interest margin. Percentage points. Quarterly figures. 87 Q1 – 07 Q3
Outlook for financial stability in Norway
The general outlook for financial stability is still considered to be satisfactory. After several years of high earnings, banks are solid and well equipped to cope with a period of weaker results.
Banks’ strong financial position is due to the solid debt�serv�
icing capacity of both households and enterprises. This has resulted in very low loan losses. Household debt is growing rapidly. Higher interest rates and somewhat lower income growth may make it more difficult to service debt ahead.
Slower growth in the Norwegian and global economies may also curb growth in corporate earnings, making it more demanding to service rising debt. Overall, banks’ loan losses are therefore expected to rise somewhat ahead.
Strong competition for customers will continue to put pressure on banks’ interest margins. In addition, growth in lending to households will probably moderate due to higher interest rates, an already high level of debt and slower house price inflation. It is also uncertain how long strong lending growth to the corporate sector can continue, and growth in banks’ net interest income will probably be slower. Due to the turbulence in money and credit markets this autumn, funding costs and losses on securities have increased, although for Norwegian banks the impact has so far been limited.
The prospect of higher losses and lower net interest income growth will put pressure on banks’ profits ahead. Profits as a percentage of total assets may be somewhat weaker in the next few years than in 2004–2007, which was a very favourable period for banks. These developments may place greater demands on banks’ cost management.
Risk outlook
The overall risk of financial instability appears to have increased somewhat since the June report, primarily due to increased uncertainty about international economic develop�
ments. We will focus on four developments in particular:
Owing to the problems in the US mortgage market and the ensuing turbulence in money and credit markets, coupled with very high oil prices, the risk of an international reces�
sion has increased somewhat since the June report. Banks in other countries have had to carry doubtful loans on their own balance sheets. As a result, capital needs will increase and banks will probably be more reluctant to extend loans.
An international recession could affect Norwegian banks through higher losses as a result of weaker earnings for
0 60 120 180 240
1985 1988 1991 1994 1997 2000 2003 2006 0 60 120 180 240 Deflated by
house rent Deflated by building costs
Deflated by disposable income2)
Deflated by CPI
1)First half of 2007
2)Disposable income less estimated reinvested dividends for the period 2000-2005
Chart 5 Real house prices. Indices. 1985 = 100.
Annual figures. 1985 – 20071)
Sources: Association of Norwegian Real Estate Agents, ECON Pöyry, Finn.no, Association of Real Estate Agency Firms, Statistics Norway and Norges Bank
10 000 15 000 20 000 25 000 30 000 35 000
1982 1986 1990 1994 1998 2002 2006 2010 -4 -2 0 2 4 6 Chart 6Market value for offices in Oslo1)
and output gap. Price per square meter at constant NOK-2007. Annual figures.
1982 – 2010
Market value (left-hand scale Output gap (right-hand scale)
1)Average value for high-standard offices in central parts of Oslo. At 30 June 2007
Sources: OPAK and Norges Bank
110 120 130 140 150 160 170 180 190
1987 1990 1993 1996 1999 2002 2005 110 120 130 140 150 160 170 180 190
Sources: Statistics Norway and Norges Bank
Chart 4Credit to mainland Norway as a percentage of mainland GDP. Quarterly figures. 87 Q1 –07 Q3
Norwegian enterprises. In addition, banks’ earnings may be reduced due to lower growth in lending and demand for other bank services in pace with lower economic growth.
The turmoil in money and credit markets has resulted in higher funding costs. If the turmoil persists or is amplified, gaining access to long�term funding could still be difficult, which will result in higher liquidity risk for Norwegian banks. Similarly, an economic crisis in the Baltic countries may have an impact on funding costs for all the large Nordic banks, including banks that are not directly affected to any extent.
Norwegian households’ high debt burden and negative saving increase the risk of an abrupt rise in the saving ratio, with potentially substantial effects on corporate earnings. One factor that may trigger changes in the saving ratio is falling house prices. In addition, the behaviour of many high�debt households has made them vulnerable to a rise in interest rates or a loss of income.
Developments in the commercial property market reflect considerable optimism. Market prices have risen substantially in the past year, partly based on expectations of continued solid growth in the Norwegian economy. If this does not materialise or interest rates are higher than participants have assumed, property companies’ profitability may be reduced, resulting in higher losses for banks. Banks have substantial loans to the commercial property industry.
The report presents stress tests that illustrate the possible consequences if some of the risk factors referred to above are triggered. The tests show that banks could incur substantially higher loan losses than in the baseline scenario. The extent of the impact on banks’ capital adequacy will partly depend on the pricing of risk and on lending growth. The stress test indicates that, due to their current financial strength, banks have a generous margin before capital adequacy falls below the minimum requirement.
1 Financial institutions
Chart 1.1 Banks’1)assets and liabilities. Per cent . 30 September 2007
1)All banks in Norway. Norwegian banks’ foreign subsidiaries and branches abroad are not included in the statistical basis Sources: Statistics Norway and Norges Bank
0 20 40 60 80 100
Assets Liabilities
Foreign assets
Equity Securities debt Lending to
Norwegian enterprises
Other liabilities Lending to
Norwegian households
Customer deposits
Deposits from financial institutions Other
Norwegian assets
Chart 1.2Banks’1)profit/loss in per cent of average total assets. Annual figures 2002-2006. Q1- Q3 06 and 072)
1)All banks excluding branches of foreign banks in Norway
2)Figures for 2007 are affected by transition to IFRS Source: Norges Bank
-3 -2 -1 0 1 2 3 4
2002 2003 2004 2005 2006 2006 2007 -3 -2 -1 0 1 2 3 4
Net interest income Other operating income Operating expenses Loan losses Write-downs etc. Pre-tax profit/loss
Q1- Q3
Chart 1.3 OSEBX and sub-indices for banks on the Oslo Stock Exchange1). 1 Jan 02 = 100. Daily.
figures. 1 Jan 02 - 29 Nov 07
1)Gjensidige NOR was moved from the primary capital certificate index to the bank index and was included in OSEBX from 13 September 2002
Source: Reuters (EcoWin) 0
50 100 150 200 250 300 350
2002 2003 2004 2005 2006 2007 0 50 100 150 200 250 300 350
OSEBX Primary capital certificate index
Bank index
Norges Bank monitors financial institutions, securities mar�
kets and payment systems in order to identify any trends that may weaken financial stability. Banking is the dominant activity of the largest financial conglomerates in Norway.
Banks play a key role in credit provision and payment services.
In addition, banks differ from other financial institutions in that they largely rely on customer deposits for funding. In analyses of financial stability, the main emphasis is therefore placed on developments in the banking sector.
1.1 Banks
Since Financial Stability 1/07, banks internationally have been affected by turbulence in money and credit markets.
Turbulence increased when it became clear that banks had to carry doubtful loans on their own balance sheets. A number of banks in Europe and the US have experienced problems as a result of the fall in prices for securities backed by US sub�
prime mortgages (see box on page 9 and Section 2.1).
Uncertainty concerning banks’ loss exposure to the US mort�
gage market has made banks reluctant to provide loans to one another. This has reduced liquidity in the interbank market, and money market rates have risen. Many central banks have supplied extraordinary liquidity to banks through their ordi�
nary lending facilities (see box on page 44).
A survey of the largest Norwegian banks by Kredittilsynet (Financial Supervisory Authority of Norway) in August 2007 showed that none of the banks was active in US sub�prime markets, but that some had limited loss exposure to hedge funds that may have invested in this market. Norwegian banks are moderately exposed to hedge funds and the US sub�prime market through claims on foreign financial insti�
tutions.
Continued solid results and solid financial strength
Chart 1.1 summarises banks’ assets and liabilities. Loans to households and enterprises account for approximately 70%
of banks’ assets. Developments in credit risk are therefore of key importance to banks’ earnings and financial stability.
Banks’ results have been solid so far this year (see Chart 1.2).
Loan losses are still very low. So far, market turbulence has had little impact. “Other income” fell somewhat in Q3 due to losses on bond portfolios as a result of increased credit risk premia on corporate bond yields. The price for funding has increased, but in the third quarter the impact on banks’
net interest income was minor becase it takes time for the increase to fully feed through to banks’ interest expenses.
The turbulence in money and credit markets has caused serious problems for several banks interna�
tionally. The impact has been felt through at least three different channels: direct loan losses, losses on securities investments and a loss of liquidity in money and capital markets.
US financial institutions that have been active in the residential mortgage market have sustained major losses. Banks that specialised in sub�prime loans are among those that have lost most. New Century Financial, formerly the next largest lender in this market in the US, filed for bankruptcy protection as early as in March 2007. New Century Financial funded its activities by selling mortgages to invest�
ment banks that issued mortgage�backed securities.
When demand for these securities fell, investment banks stopped buying mortgages and New Century Financial lost its funding.
Countrywide Financials is another major partici�
pant in the US mortgage market. Until August, Countrywide Financials funded a large share of its loans through the commercial paper market.
When it became difficult to obtain funding in the commercial paper market, the company faced serious liquidity problems. So far, the lender has solved its problems by issuing convertible bonds and borrowing from the Federal Home Loan Bank.
Countrywide Financial reported losses of USD 1.2bn in the third quarter and total losses of almost USD 300m in the first three quarters of 2007. At the end of the third quarter, the bank’s total assets and equity amounted to USD 209bn and USD 15bn, respectively. In its quarterly report, the company maintained that there are prospects of a surplus in the fourth quarter. Share prices reacted positively to the report but Standard & Poor’s downgraded the company from A� to BBB+.
Many banks have invested in securities backed by sub�prime mortgages via special purpose vehicles, which are off�balance sheet conduits. These vehi�
cles tend to rely on the commercial paper market for funding. Backed by highly rated assets and a credit line from the originator bank, they obtained favour�
able borrowing conditions. The German bank IKB Deutsche Industriebank faced serious liquidity prob�
lems at the end of July when its conduit Rhineland Funding had to draw EUR 8.1bn on IKB’s credit line. The principal shareholder, the state�controlled German bank KfW, provided a
guarantee for IKB’s continued operation. Financial institutions that had not invested in the US sub�
prime mortgage market also developed problems as a result of loss of liquidity in the money market.
The British bank Northern Rock, the fifth largest mortgage bank in the UK, was hard hit. The agen�
cies that conducted a credit rating of Northern Rock described the financial strength of the bank and the quality of the bank’s loans as high, but the bank’s financing was dependent on the issue of mort�
gage�backed securities. The credit rating agencies had pointed out the bank’s vulnerability to failing demand for these securities. Until 14 August 2007, the bank was virtually unaffected by the problems in the US mortgage market. At that time there was a general loss of liquidity in international money and credit markets. These markets were Northern Rock’s most important source of funding, and the bank was hard hit. The price of five year’s credit insurance for the bank’s debt rose immediately from about 0.3 to 1 percentage point annually. The share price had been falling for a long period, but did not change much at this point in time. UK money market rates rose in August and September, exacer�
bating the funding situation. On 13 September it became known that Northern Rock had requested and been offered emergency financial support by the Bank of England, and customers flocked to the bank to withdraw their money. The share price fell by a further 75%. At that time Northern Rock had limited access to funding and was dependent on government loans. The government had also provided a guarantee for old and new customer deposits.
Problems in some foreign financial institutions
0 50 100 150 200 250 300 350 400
2001 2002 2003 2004 2005 2006 2007 20080 50 100 150 200 250 300 350 400
Chart 1Share prices for financial institutions and global finance equity index. 1 Jan 01 = 100. Daily figures. 1 Jan 01 – 29 Nov 07
Source: Reuters (EcoWin) Northern Rock
Countrywide
IKB
Finance equity index
10
Northern Rock will have to restore investor confi�
dence before it can expect to secure normal market funding. The company has appointed a new board chairman and has been negotiating with a number of counterparties on a permanent funding solu�
tion. At 26 November the board announced that
they wanted to take forward discussions with a consortium of investors led by Virgin Group.
The consortium is proposing to merge Northern Rock and Virgin Money under the Virgin brand name.
Return on equity in the largest Norwegian banks is solid compared with other Nordic financial conglomerates (see Annex 3, Table 7). The market turbulence does not appear to have curbed analysts’ profit expectations. So far this year, profit expectations for 2008 have increased for both DnB NOR and medium�sized savings banks. As in many other countries, price movements on the Oslo Stock Exchange have nevertheless been weaker for banks than for other enterprises. Since year�end, the Oslo Stock Exchange’s primary capital certificate index has fallen by 8%, while the bank index has increased by 1% (see Chart 1.3). Weaker developments for banks than for other enterprises may be a sign that the risk premium investors require of banks has increased.
The financial strength of Norwegian banks is solid. The capital adequacy ratio for Norwegian banks as a whole was 11.2% at the end of 2007 Q3 (see Chart 1.4). In isolation, strong growth in lending is weakening capital adequacy.
Stable total interest margin
Banks’ total interest margin1 increased in the second quarter after falling substantially in recent years (see Chart 1.5). In the third quarter the interest margin was nearly unchanged.
The lending margin fell substantially in the third quarter, while the deposit margin rose equivalently. The reason was that both lending and deposit rates increased less than money market rates, which rose sharply in the third quarter.
At end of quarter the lending margin on mortgage loans was negative (see Chart 1.6).
Until recently, the increase since June 2005 in Norges Bank’s key policy rate had not fully fed through to inter�
est rates charged on loans to households and enterprises.
There are several reasons for this. Lending margins were fairly high in summer 2005, while deposit margins were
0 2 4 6 8 10 12 14 16
Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 0 2 4 6 8 10 12 14 16
Core capital ratio2) Capital ratio2)
Chart 1.4 Banks’1)capital ratio (Tier 1 + Tier 2) and core capital ratio (Tier 1). Per cent.
Quarterly figures. 02 Q1 – 07 Q3.
1)All banks excluding branches of foreign banks in Norway
2)In 2007Q1 eight banks reported according to Basel II. In Q2 and Q3 the figure had increased to ten. Other banks reported according
to Basel I
Sources: Norges Bank and Kredittilsynet If all banks were still reporting according to Basel I in 2007
Chart 1.5 Banks’1)total interest margin divided into deposit and lending margin2). Percentage points.
End of quarter. 97 Q2 – 07 Q3
1)All banks in Norway
2)Deposit and lending margins are measured against 3-month money market rates
3)As interest rates on deposits can not be negative, the deposit margin is low when money market rates are low
Source: Statistics Norway -0.5
0 0.5 1 1.5 2 2.5 3 3.5 4
1997 1999 2001 2003 2005 2007-0.5
0 0.5 1 1.5 2 2.5 3 3.5 4 Total interest margin
Lending margin
Deposit margin3)
1 The interest margin is defined as the average lending rate minus the aver�
age deposit rate. The interest margin shows what banks earn from lending when loans are financed by deposits. The 3�month money market rate (NIBOR) is used to divide the interest margin into the lending margin and the deposit margin. The lending margin is defined as the lending rate minus the money market rate, whereas the deposit margin is the money market rate minus the deposit rate. The lending rate in the statistics is annualised, but does not include arrangement fees and instalment charges (commission on lines of credit are included). The lending rate is therefore not entirely an effective rate. As a result, the estimated lending margin and total interest margin are somewhat underestimated.
11
low because of very low money market rates. With the new Basel II capital adequacy rules, capital requirements for most loans are lower. Loan losses are also low due to favourable economic conditions, resulting in lower credit risk premia in lending rates. Furthermore, the 6�week notification deadline for interest rate increases on retail loans may delay banks’
adaptation to higher short�term interest rates.
In the second half of 2007, the spread between the money market rate and the key policy rate increased substantially (see Chart 2.5, page 16). Over time, a substantially higher money market rate will influence banks’ average funding costs, and will therefore probably be passed on to the banks’
borrowers. Over the past few months a number of banks have increased their lending rate to a further extent than the increase in the key policy rate.
Continued strong lending growth
Banks’ and mortgage companies’ lending growth has been high for several years. The combined year�on�year lending growth for these institutions has eased in recent months (see Chart 1.7).
The potential for future loan losses is increasing due to strong lending growth. Non�performing loans as a share of total lending to municipalities, non�financial institutions and households have declined markedly since 2003 Q2 due to favourable developments in household and corporate finances.
The share is very low for both enterprises and households (see Chart 2 in Summary).
Loans to the retail market account for approximately 55%
of combined bank and mortgage company lending to house�
holds, non�financial enterprises and municipalities. Around 90% of these loans are mortgage loans (including flexi�
loans). Experience shows that the risk of default on mortgage loans is low. Since mortgage loans represent a large portion of banks’ loan portfolios, the value of banks’ collateral will vary with fluctuations in house prices. Approximately 90%
of bank loans secured on residential property are within 80% of a sound valuation. Figures do not include banks that apply internal methods under Basel II for reporting capital adequacy. In its survey of mortgage financing in eight banks, Kredittilsynet found that a number of banks overestimate customers’ liquidity surplus. Most banks have relaxed the requirements for interest�only loans. Kredittilsynet points out that this increases credit risk on loans to customers with a weak debt�servicing capacity. A substantial number of loans deviate from banks’ internal credit policy guidelines.
Bank and mortgage company lending to the corporate market is growing rapidly. Lending to property management and commercial services and to the construction and utilities sec�
Chart 1.6Banks’1)lending margins.
06 Q4 – 07 Q3. Percentage points
-0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1
Non-financial
private enterprises Households Home equity
lines of credit Repayment loans secured on
dwellings
-0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8
2006 Q4 1
2007 Q1 2007 Q2 2007 Q3
1)All banks in Norway
Sources: Statistics Norway and Norges Bank
-4 0 4 8 12 16 20 24
2000 2001 2002 2003 2004 2005 2006 2007 -4 0 4 8 12 16 20 24
1)All banks and mortgage companies in Norway Source: Norges Bank
Corporate sector
All sectors Retail sector
Chart 1.7 Growth in banks’ and mortgage companies’1)lending. 12-month growth.
Per cent. Monthly figures. Jan 00 – Oct 07
Chart 1.8 Growth in banks’ and mortgage companies’1)lending to selected industries. Per cent. Four-quarter growth. 02 Q1 – 07 Q3
1)All banks and mortgage companies in Norway Source: Norges Bank
-10 0 10 20 30
2002 2003 2004 2005 2006 2007
-10 0 10 20 30
Manufacturing Construction and utilities Retail trade, hotel and restaurant Property mangement and commercial services
12
tors is growing fastest (see Chart 1.8). Property manage�
ment and commercial services account for the largest share of loans from banks and mortgage companies. These loans accounted for 19% of banks’ and mortgage companies’
total loans at the end of 2007 Q3. The share is higher for large banks than for small banks.
Higher financing costs
Deposits from municipalities, non�financial enterprises and households are regarded as a stable form of funding, and in recent years have accounted for 60�65% of lending to this sector (see Chart 1.9). Retail customer deposits have declined, while corporate deposits have increased (see Chart 1.10). The increase in corporate deposits reflects a marked increase in corporate liquidity holdings (see Section 2.4).
On the whole, corporate deposits tend to be more volatile than retail deposits. Enterprises are in a stronger price negotiation position and can probably consider alternative investments more easily than households. This may be one reason why banks offer higher deposit rates to enterprises than to households.
Non�deposit funding may be more expensive and more exposed to changes in market conditions, as Norwegian banks experienced during the turbulence in the second half of 2007. In August, banks in many countries had problems procuring liquidity in US dollars.
The bond market has gradually become a more important source of funding for banks (see Chart 1.10). The decline in 2007 may have occurred because it has become attractive for banks to issue long�term bonds via mortgage companies (see box on page 47). In addition, the market unrest may have curbed banks’ plans for new issues of their own.
In the second half of the year, the spread between yields on government securities and the rates banks pay for borrowing in money and bond markets increased considerably (see Chart 1.11). The pronounced rise in money market rates makes short�term financing more expensive. Banks largely extend long�term loans at floating rates, so they also prefer floating rates on long�term borrowing. When banks issue bonds at fixed rates, they convert their interest payments to floating money market rates by means of interest rate swap agreements. This means that higher money market rates also make long�term funding more expensive.
Banks’ short�term debt as a share of total debt has increased somewhat in 2007 (see Chart 1.12). This does not include customer deposits. In recent years, short�term domestic funding as a share of total debt has declined for medium�
sized banks, but has increased somewhat in the third quarter (see Chart 1.13). With the exception of DnB NOR, short�term foreign debt accounts for a small portion of Norwegian banks’ funding (see Chart 1.14).
1)All banks except branches and subsidiaries of foreign banks in Norway
Source: Norges Bank
Chart 1.9 Norwegian banks’1)share of deposits.
Deposits from customers in per cent of lending to customers. Quarterly figures. 00 Q1 – 07 Q3
50 55 60 65 70 75 80
2000 2001 2002 2003 2004 2005 2006 2007 50 55 60 65 70 75 80
1)All banks except branches and subsidiaries of foreign banks in Norway
Source: Norges Bank
Chart 1.10 Norwegian banks’1)funding sources.
Percentage of gross lending. Quarterly figures.
00 Q1 – 07 Q3
0 10 20 30 40
2000 2001 2002 2003 2004 2005 2006 2007 0 10 20 30 40
Bonds
Notes and short-term paper Deposits / loans from financial institutions Deposits from retail sector
Deposits from corporate sector
Chart 1.11 5-year yields on Norwegian government and bank bonds. 3-month money market
(NIBOR) and treasury bill rates. Weekly figures.
3 Jan - 28 Nov 07. Per cent
Sources: Reuters (EcoWin) and DnB NOR Markets
0 1 2 3 4 5 6 7
Jan-07 Apr-07 Jul-07 Oct-07 0 1 2 3 4 5 6 7
Government bonds Bank bonds
Treasury bills
Money market
1
More than half of total debt, excluding customer deposits, is in foreign currency (see Chart 1.15). This makes banks vul�
nerable to unrest in foreign money and credit markets. Banks limit currency risk by using currency derivatives.
The liquidity indicator2 shows that there is still a favourable balance between stable funding sources and illiquid assets at DnB NOR and small banks (see Chart 1.16). The liquidity indicator for the medium�sized banks has improved appre�
ciably in recent years, but weakened somewhat in the third quarter.
Each year, Kredittilsynet and Norges Bank conduct a survey of the largest Norwegian banks’ exposures to their counter�
parties in transactions. The most recent survey was based on figures at 30 March 2007. Few of the exposures were so large that the banks’ financial strength would be seriously compromised if a major counterparty could not meet its obli�
gations. Following the inclusion of NOK in the international settlement system CLS (Continuous Linked Settlement) in 2003, most of the credit risk associated with settlement of foreign exchange has been eliminated and liquidity risk has been reduced. The increased spread between money market rates and yields on treasury bills in the second half of 2007 may be a sign that banks generally assess counterparty risk as higher than previously.
A relatively small portion of Norwegian banks’ assets are directly exposed to market fluctuations. Equities held as cur�
rent assets account for 0.6% of banks’ total assets. Market risk may nevertheless be important to banks that are part of a conglomerate that includes life insurance companies.
1.2 Other financial institutions
Total profits of mortgage companies fell substantially in the third quarter, partly because Eksportfinans ASA posted a negative result. As a result of developments in credit markets, the company recorded unrealised capital losses on bonds in its liquidity portfolio, which is larger than other mortgage companies’ liquidity portfolios.
Several new bank�owned mortgage companies have been established in the past two years. This must be viewed in the light of new rules providing for the issuance of covered bonds, which came into force on 1 June 2007 (see box on page 47)
Chart 1.12 Banks’1)liabilities by maturity.
Customer deposits are excluded. Per cent. Year- end 2004-2006, and Jun and Sep 2007
0 10 20 30 40 50 60 70 80 90 100
2004 2005 2006 jun.07 sep.07
Less than 1 month 1 - 3 months 3 - 12 months 1 - 5 years More than 5 years
1)All banks except branches and subsidiaries of foreign banks in Norway
Source: Norges Bank
Chart 1.13 Norwegian banks’1)short-term domestic debt2). Per cent of gross lending.
Quarterly figures 00 Q1– 07 Q3
1)All banks except branches and subsidiaries of foreign banks in Norway
2)Short-term paper debt, deposits and loans from other financial institutions
3)DnB NOR Bank (excluding branches abroad) and Nordlandsbanken 4)The dividing line between small and medium-sized banks is NOK 10bn (measured by assets) at end-2006
Source: Norges Bank 0
5 10 15 20 25
2000 2001 2002 2003 2004 2005 2006 2007 0 5 10 15 20 25
Medium sized banks4) Small banks 4)
DnB NOR 3)
Chart 1.14 Norwegian banks’1)short-term foreign debt2). Per cent of gross lending.
Quarterly figures. 00 Q1 – 07 Q3
1)All banks except branches and subsidiaries of foreign banks in Norway
2)Short-term paper debt, deposits and loans from other financial institutions
3)DnB NOR Bank (excluding branches abroad) and Nordlandsbanken 4)The dividing line between small and medium-sized banks is NOK 10bn (measured by assets) at end-2006
Source: Norges Bank 0
5 10 15 20 25
2000 2001 2002 2003 2004 2005 2006 2007 0 5 10 15 20 25 DnB NOR 3)
Medium-sized banks 4)
Small banks 4)
2The liquidity indicator is calculated as the ratio of stable funding sources to illiquid assets. An increase in this ratio indicates a lower risk of liquidity problems. Deposits from households, non�financial enterprises and munici�
palities, bonds, subordinated loan capital and equity are regarded as stable financing. Illiquid assets include gross lending to households, non�financial enterprises and municipalities, other claims, assets acquired by recovery of claims and fixed assets. Off�balance sheet items, such as drawing facilitites and unused lines of credit, are not included.
1
Chart 1.16 Norwegian banks’1)liquidity indicator (ratio of stable funding sources to illiquid asets). Per cent. Quarterly figures.
00 Q1 – 07 Q3
1)All banks except branches and subsidiaries of foreign banks in Norway
2)DnB NOR Bank (excluding branches abroad) and Nordlandsbanken
3)The dividing line between small and medium-sized banks is NOK 10bn (measured by assets) at end-2006
Source: Norges Bank 80
90 100 110 120
2000 2001 2002 2003 2004 2005 2006 2007 80 90 100 110 120 DnB NOR2)
Small banks3)
Medium-sized banks3) DnB NOR including foreign
branches, borrowers and depositors
1)Buffer capital is defined as the sum of the security adjustment reserve, supplementary provisions with an upward limit of one year, and surplus of Tier 1 capital
2)From 2007 other bonds for permanent investment are also included
Source: Kredittilsynet
Chart 1.17 Life insurance companies’ buffer capital1)and asset mix. Per cent of total assets.
Quarterly figures. 01 Q1 – 07 Q3
0 10 20 30 40
2001 2002 2003 2004 2005 2006 2007 0
10 20 30 40
Real estate Equities and shares
Buffer capital
Bonds ”hold to maturity“ 2)
Bonds and short- term paper
Finance companies are a diverse group serving a number of different markets. At end�September 2007, year�on�year growth in their lending was 19%. Unsecured consumer loans have a high credit risk. Companies charge consumers for the credit risk through high effective interest rates. Finance companies’ results for the first three quarters of 2007 were solid.
Life insurance companies’ value�adjusted profits in the first three quarters of 2007, measured as a share of total assets, were higher than in the same period in 2006. Their buffer capital was 7.0% of total assets at the end of 2007 Q3, almost unchanged from the same time a year earlier.
Life insurance companies are more exposed to market risk than banks, since a far higher share of their total assets is invested in equities and bonds. At the end of 2007 Q3, fixed income instruments and equities accounted for 80% of total assets, while property accounted for 11% (see Annex 3, Table 9). The equity portion fell somewhat in the third quarter, after climbing markedly in recent years (see Chart 1.17). Kredittilsynet’s September survey of the largest life insurance companies shows that the companies had little direct exposure to the US sub�prime market. In the third quarter the companies recorded almost NOK 3bn in net unrealised losses on corporate bonds and commercial paper.
This is equivalent to 0.4 per cent of total assets.
Chart 1.15Selected funding sources for Norwegian banks’1). 30 Sep 2007. In billions NOK
0 500 1000 1500 2000
NOK Foreign currency
0 500 1000 1500 2000 Bonds
Short-term paper Deposits from financial inst.
Deposits from customers
1)All banks except branches and subsidiaries of foreign banks in Norway
Source: Norges Bank
1 0
3 6 9 12
US Euro area Japan China Trading partners
0 3 6 9 2006 2007 12
2008 2009
Chart 2.1GDP growth abroad. Increase on previous year in per cent. Forecasts for 2007 – 20091)
1)Forecasts in Monetary Policy Report3/07 Sources: IMF and Norges Bank
1100 1300 1500 1700 1900 2100 2300
2003 2004 2005 2006 2007 -5
0 5 10 15 20
Chart 2.2 12-month rise in house prices1)and housing starts in the US. Monthly figures.
Jan 03 – Oct 07
1)Median price in USD. Existing homes Source: Reuters (EcoWin)
Housing starts in 1000s (left-hand scale)
House prices (right-hand scale)
-5 0 5 10 15 20 25 30 35
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 -5 0 5 10 15 20 25 30 35 Chart 2.3 House prices in Europe. 4-quarter rise.
Per cent. Quarterly figures. 98 Q1 – 07 Q3
Source: Reuters (EcoWin) Ireland
UK Denmark
France
Spain
The macro-financial environment
2
Loans to Norwegian enterprises and households account for a large share of banks’ assets (see Chart 1.1). Developments in these sectors are therefore crucial for banks’ losses and results. International conditions are also important for financial stability in Norway. Global economic growth and movements in interest and exchange rates affect the finan�
cial position of Norwegian households and enterprises, and thereby banks. Developments in securities markets influence Norwegian financial institutions’ market and liquidity risk and companies’ access to funding.
2.1 International developments and securities markets
Somewhat weaker global growth
Growth in the global economy remains strong (see Chart 2.1), partly as a result of very high growth in China, India and some other Asian countries. Uncertainty about growth ahead has been amplified by the turmoil in money and credit markets this autumn. As a result of this turmoil and the sluggish US housing market, the estimates for growth in the US next year are lower than at the time of Financial Stability 1/07. Growth in western Europe in 2008 has also been revised down. Overall, the global growth outlook is somewhat weaker than at the time of the previous report.
Global imbalances
The US current account deficit is still high. This deficit is to a great extent matched by large surpluses in oil�exporting countries and countries in Asia. Economic developments in recent years have to some extent reduced the imbalances in world trade. The US current account deficit narrowed in the second quarter. The US dollar has fallen against other currencies. This may lead to increased exports and reduced imbalances in the period ahead.
Weaker housing markets in a number of countries Activity in the US housing market has been very high in recent years. After many years of sharply rising house prices, house price inflation slowed markedly in 2006, and prices have fallen in 2007 (see Chart 2.2). House price inflation has also slowed in several European countries (see Chart 2.3).
In Ireland and Denmark, house prices fell in 2007. The fall in house prices may contribute to weaker economic growth through slower growth in housing investment and private consumption. In addition, lower house prices reduce the value of banks’ collateral.
1
0 10 20 30 40 50 60 70 80 90 100
Jan 07 Apr 07 Jul 07 Oct 07 0
10 20 30 40 50 60 70 80 90 100 Chart 2.6 Global change in credit ratings of private enterprises’ debt.1)Monthly figures.
Per cent. Jan 07 – Nov 07
Upgrades
Downgrades
1)Long-term and short-term credit ratings from S&P. Enterprises and debt securities
Source: Bloomberg 0
3 6 9 12
2002 2003 2004 2005 2006 2007 20080 3 6 9 12
Chart 2.5 Credit spread against government bonds in the US and Europe. Percentage points. Daily figures.1 Jan 02 – 29 Nov 07
Source: Reuters (EcoWin)
Emerging economies, EMBI+
High yield companies in the US
Europe, BBB US, BBB 0
0.25 0.5 0.75 1 1.25
May 07 Jul 07 Sep 07 Nov 07 0 0.25 0.5 0.75 1 1.25 Chart 2.4Spread between money market rate and expected key rate.1)3-month maturity.
Percentage points. 1 Mai 07 – 29 Nov 07
Norway2) UK
Euro area US
1)Expected key rates are measured by Overnight Indexed Swaps (OIS)
2)Norges Bank’s projection
Sources: Bloomberg and Norges Bank
Problems in the US mortgage market
Higher interest rates and falling house prices have led to rising defaults and losses on mortgages in the US. The increase in defaults is associated primarily with sub�prime and Alt�A loans (see box on page 42).
More than half of all mortgages in the US are sold on by banks to other investors through the issue of mortgage�
backed securities. These securities are bought by insurance companies, funds and other asset managers in the US and other parts of the world, and these operators will therefore have to bear a substantial share of the losses. Nevertheless, banks have been left with much of the credit risk. They have had their own holdings of securities, sold credit insurance and issued credit lines to companies (special purpose vehi�
cles) that have invested in these securities.
The diversification of credit risk through securitisation has led to a lack of information about which investors bear the risk on doubtful loans. There has been considerable uncertainty about the extent of losses at large financial institutions. The price of insurance against losses on loans to these institutions has risen considerably (see Chart 3.1 on page 31).
Liquidity problems
The turmoil in the mortgage market spread quickly to money and credit markets. It became clear that many banks in the US and Europe would have to bring doubtful loans back onto their balance sheets. In August, uncertainty about who would incur larges losses on mortgage bonds, and about the size of these losses, made banks the world over more reluc�
tant to lend to each other. Many banks became uncertain about both their own and other banks’ future liquidity. As a result, the spread between money market rates and expected key policy rates widened markedly in the US and other countries (see Chart 2.4). This spread is still abnormally wide. The liquidity shortage was an important reason why the problems in the US mortgage market spread to other countries. Norwegian banks were also affected. Several central banks injected large amounts of short�term liquidity into the banking system (see also box on page 44).
The turmoil in money and credit markets subsided in September and October. In November, uncertainty flared up again when banks had to acknowledge that losses were larger than previously assumed, and the spread between money market rates and expected key rates widened again.
This has resulted in higher funding costs for financial insti�
tutions that rely on short�term loans.
Weaker bank results
Banks and financial institutions both within and outside the US have reported higher losses on US sub�prime mort�
1 Source: Reuters (EcoWin)
Chart 2.7 10-year government bond yield. Per cent.
Daily figures. 2 Jan 97 – 29 Nov 07
0 2 4 6 8 10
1997 1999 2001 2003 2005 2007 0 2 4 6 8 10 UK
Germany
Norway
US
Source: Reuters (EcoWin)
Chart 2.8 Equity indices. 2 Jan 97 = 100.
Daily figures. 2 Jan 97 – 29 Nov 07
0 100 200 300 400
1997 1999 2001 2003 2005 2007 0 100 200 300 400
Europe Stoxx
Norway OSEBX
US S&P 500
Sources: Reuters (EcoWin) and Norges Bank Chart 2.9 P/E for the US and Europe. Estimated earnings over the last 12 months. Monthly figures. Jan 96 – Sep 07
0 5 10 15 20 25 30 35 40
1996 1998 2000 2002 2004 2006 0 5 10 15 20 25 30 35 40 Europe Stoxx US S&P 500
gages. They have also had to take doubtful loans back onto their balance sheets. Higher funding costs, coupled with to some extent lower activity in the housing market, has led to weaker earnings.
Even if banks’ losses on mortgage lending are not large, the effects on their balance sheets and capital adequacy may be considerable. If banks are unable to sell the mortgages they have already issued through securitisation, total assets will rise and banks capital provisions will have to increase to meet capital adequacy requirements. In the same way, banks may have to meet capital requirements for assets transferred from special purpose vehicles to banks balance sheets, and for committed credit lines or loans to such vehicles. Higher capital needs may induce banks to show greater overall restraint in the provision of credit.
The European Central Bank’s October 2007 bank lending survey indicates that European banks’ credit standards have been tightened somewhat. The turmoil in money and credit markets has resulted in increased liquidity risk for banks and financial institutions in a number of countries. A sharper focus on liquidity risk and balance sheet management may result in greater competition for deposits and more emphasis on long�term funding.
Increased risk premiums and rating downgrades Robust earnings and low default rates, together with increased demand for fixed income securities, led to a gradual narrowing of credit spreads between corporate and government bonds from 2003 until summer 2007 (see Chart 2.5). When the problems in the US mortgage market flared up in July, spreads increased markedly. Besides expectations of weaker growth and higher bankruptcy probabilities, this increase may be a sign that investors in general are now demanding higher risk premiums for keeping these securities. Reduced risk willingness, for example as a result of losses on mort�
gage�backed securities, may have contributed to the increase in risk premiums. Reduced liquidity in credit markets and higher spreads in the money market may also be having an impact.
The turmoil in financial markets is also reflected in a substan�
tial rise in the number of rating downgrades of private com�
panies’ debt through autumn, while the number of upgrades has fallen (see Chart 2.6).
Lower long-term yields
Long�term government bond yields in the US, Europe and Norway rose up to summer, but have since fallen again (see Chart 2.7). This fall partly reflects investors’ flight to safety and partly expectations of weaker economic growth and lower key rates. Lower long�term yields are mainly due to a fall in real interest rates.
